There are two major components of this invention. The first involves the utilization of a minimum annualized rate of return (or maximum rate of loss) in determining when an investment is automatically sold. This rate of return can be relative to the initial purchase price and/or relative to other investments. The second aspect involves a mechanism that allows for all or a portion of the invested capital to be returned to the investor once a predetermined capital gain criterion is met. Even though the broker returns a portion of the underlying capital, the investor continues to enjoy the capital gains until such time the investment is sold. In exchange for this privilege, the broker could command a higher commission rate from the investor, perhaps by sharing a percentage of the capital gains.
Rate of Return Stop
Investors carry a heavy burden of monitoring the value of their investments. From the time of purchase until such time the investment is sold, they must constantly monitor the value of the investment. This monitoring burden is compounded when numerous investments have been purchased. Factoring in price volatility, the need to continuously monitor the valuation is further intensified.
There are numerous methods to either monitor the valuation of investments or sell them on behalf of investors. One major difference between the present invention and other “sell order stops” is that “rate of return stops” monitors what matters most to investors—the rate of return, not just an absolute gain.
Some of those “sell order stop” methods simply monitor and notify the investor when an absolute predetermined value is met. Other methods communicate and/or actually trigger a sell order automatically once the investment reaches predetermined valuation level. Often the “trigger” price is based upon some value below the initial purchase price, thereby protecting from further loss; or it is based upon a predetermined appreciation level, thereby preserving the capital gain. For example, a notification and/or sell order may be automatically executed if a stock falls below $95 or above $100. Basic stop and limit orders have been in existence for decades.
Some stop orders are highly sophisticated. trailing stops, for example, follow the appreciated value of the investment. The sale of the investment is based upon the highest appreciated value, less a predetermined amount. For example, a stock purchased at $50 that appreciates to a high of $60 may be triggered by a sell order once the valuation reaches $58, or, stated differently, its highest valuation amount, less a predetermined value of $2. Other versions of the same concept include, “Turtle Trading”, “Price Channel Breakouts” and “Donchian Breakouts”. In all these instances, the trigger price is based upon an absolute market value of the investment—not the investor's rate or return.
There are a number of inherent risks in these approaches. The notification only approach could cause a delay in reaction time. The investor that receives the phone call must find time to request a sell order via a broker or electronically. In that time, the valuation could decline. Either the amount of the appreciated gain is lost or, worse, the delayed reaction time may even wipe out a portion of the initial invested capital.
Even those methods that trigger a sell order automatically have a major inherent risk. They do not take into consideration each investor's desired rate of return. The sell order triggers are based upon an absolute value—either relative to the initial purchase price or the highest valuation—not what the investor desires from a rate of return perspective. For example, the rate of return for a stock purchased at $50 and sold at $58 is very different from the rate of return on a $100 purchase that is sold at $108. In both cases the capital gain value is $8. However an $8 gain on $50 is a 16% return; versus an 8% gain on $100.
These other approaches also do not take into account the “time value of money”. What investors care about more than anything else is their rate of return. Not an absolute appreciation value. This is a critical distinction relative to traditional approaches.
Which has a better rate of return, a stock that is purchased at $100 and sold 30 days later at $103, or the same stock purchase that is sold in 200 days at $108? If the more traditional approaches were used, the trigger price would likely be $108, or a 15% annualized return. Conversely, if a rate of return approach were used, the stock would have been sold at $103, or a 43% annualized rate of return. In the former, dollar based approach, 170 days—and 3 times the rate of return—would have been wasted. In the latter case, the investor can fully capture the 43% annualized rate of return and then reinvest in other high return investments, thereby compounding the cumulative rate of return.
Another consequence of using either the basic stop orders or more sophisticated versions of stop orders is they actually cause more volatility in the market. If a large percentage of investors choose to sell based upon similar valuation based criteria, then the market price will drop precipitously. Under such circumstances there are simply too many sellers relative to buyers. The rate of return approach significantly limits the onslaught of sellers. Since each investor purchases at a different prices, at a different time-frame, and each have a unique rate of return criteria, the likelihood of numerous investors wanting to sell at the same time is sharply reduced, thereby reducing potential market volatility.
Another common means of protecting a loss relative to the initial investment value is the use of options. Options provide the investor with the right—not the obligation—to purchase (in the case of “call options”) the underlying investment. For example, an option that is purchased on a stock that is trading at $75 and has a strike price of $80 wouldn't be a loss to an investor if the stock never exceeds $80—other than the transaction costs (the price of the option plus commissions). Therefore the risk of losing the transaction cost on options is very likely, relative to other investment types. They also have other limitations. They also do not take into account the investor's unique rate of return or the “time value of money”. They also have a limited duration in which they expire. Rate of return stops can last in perpetuity so long a sell order is not triggered.
With options investors not only need to constantly monitor the option price itself, but they also have to simultaneously monitor the price of the underlying asset. If the option price increases, the investor may choose to sell the option itself. If the value of the underlying asset improves relative to the absolute value of the “strike price”, then the investor may “exercise” the option.
Futures, another common investment instrument, have many of the same limitations as options. In addition, futures are largely limited to commodities, such as grain, livestock, metals, currency, and oil—not all asset types.
The present invention can be used on the purchase of stocks, bonds, options, futures, indices, mutual funds and all other investment instruments that have market based fluctuating valuations.
In the same way a minimum rate of return can be established at the time or purchase or thereafter, the maximum rate of loss can also be utilized. An investor, for example may establish a minimum annualized rate of return of 10% and a maximum annualized rate of loss of 4%. Therefore the investor can simultaneously minimize a loss and protect a capital gain.
Another unique advantage of rate of return stops is to compare rate of return relative to other investments. In particular an investor can choose to trigger a sell order in the event other investment(s) are significantly outperforming the current investment. For example, if the current investment at the prevailing market price has a rate of return of 1%, and comparison investment(s) have returns of 5-6%, the investor may choose to trigger a sell order and/or purchase order to buy those comparison investments. There are no known stops or financial instruments that have such a comparison on a relative basis.
So rate of return stops have a number of advantages over traditional stops and even other financial instruments. It addresses what matters most to investors—the annualized rate of return. They can be used on all assets types, they are not limited in duration, and they are less volatile in the general market.
Capital Return
In today's investment environment, when an investment is made, the initial capital is tied up until such time it is sold. Meanwhile other investment opportunities come and go, leaving the investor on the sidelines from other, potentially more lucrative investment opportunities. The investor is faced with a dilemma: either sell the current investment to reinvest in yet another, or hold the current investment in hope of generating a better overall return. Both options have inherent risks.
Another alternative is for the investor to take out a loan, using the investment as collateral. With exception to brokerages, most financial institutions would not consider such a loan, given the uncertainty of future valuations. Other financial institutions would only offer a loan at 60% of less of the valuation, and likely charge a higher interest rate. In either scenario, financial institutions view collateral against investments as risky because of price volatility and, most importantly, because they do not control the conditions at which the investment is sold.
Certainly the investor has the option of “buying on margin”—or borrowing from the broker at the time of purchase. This allows investors with the ability to in effect hold aside a portion of their investment capital until such time another investment opportunity comes available. Not only do margin accounts involve a interest payment for the privilege of borrowing, but brokers are limited in the percentage of the investment value they can loan. Typically this limitation is 40%. Another consequence of holding aside investment capital is that those finds are not generating a sizable return. Investors that hold funds in money market and other high liquidity accounts, get a very low rate of return. This rate of return is far lower than the cost of borrowing on a margin account, thereby creating a net loss transaction.
Another aspect of this invention involves a guaranteed sell order price. Today when a sell order price is established (either manually or via sell order stops), the sell order itself is not initiated until the current market price equals the threshold price. Since other investors' sell orders may be “ahead,” those are processed first. By the time the sell order is actually executed, the market price may have worsened. The guaranteed sell order price would eliminate the investor's risk of price deterioration, wherein the broker anticipates the best timing to sell the investment. The guaranteed sell order price applies to rate of return, capital return and all traditional transactions.